Fed expected to cut discount rate after global move

On Wednesday, the Federal Reserve and other central banks agreed to cut the cost for commercial banks to borrow dollars from the central banks. The move was aimed at European banks, which have seen their dollar funding costs spike to three-year highs on worries about huge losses on sovereign debt. Up next should be a cut in the cost for U.S. banks to borrowing from the Fed if they need, analysts said.

“It is now cheaper for foreign banks to borrow dollars from their local banks than it is for U.S. banks to borrow dollars from the Fed, so we could see a 25 basis point cut in the discount window in the coming days to level the playing field,” said Michael Cloherty, head of U.S. rates strategy at RBC Capital Markets.

Incidentally, some Fed officials have wanted to do the opposite – increase the discount rate – to get it back towards its level before the U.S. credit crisis. That’s according to minutes from Fed discount-rate meetings in October, released Tuesday. Read minutes from Fed discount-rate meetings.

The central banks on Tuesday agreed to lower the pricing on existing temporary U.S. dollar liquidity swap arrangements by 50 basis points, putting the new rate as the U.S. dollar overnight index swap rate plus 50 basis points. A basis point is one one-hundredth of a percentage point. Read full story on central-bank swap move.

Cloherty and others had mused that the Fed could cut the swap rate by 25 basis points. But global central banks were more aggressive and cut it 50 basis points. The move should keep the market rate for bank borrowing – the London Interbank Offered Rate, or Libor — from jumping because it makes the swap lines an economically smart option, he said.

But the reaction in markets – a sharply higher euro EURUSD and stocks (Dow Jones Industrial Average DJIA up 428 points) and drop in Treasury prices 10_year – may be overdone.

“It doesn\’t change any of the fundamental issues in Europe,” Cloherty wrote in a note. “The major help to risk assets is that those investors no longer will need to see LIBOR rise relentlessly (and it should make year-end a little less messy), but we don\’t think this is a real game-changer.”

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